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Global markets may be converging on a new ‘volatile’ norm as investors revalue risk, as governments begin the painful process of deleveraging to more sustainable debt levels. Thus far fears of sovereign defaults have remained contained to the usual suspects—fundamentally weak nations—leading investors to flock to the safe-havens of the U.S., Japan, and Germany. Risk aversion has pushed 10Y German Bund yields down to a multi-decade low of 2.632%; while 10Y U.S. Treasuries are yielding 3.113% from nearly 4% in April. Yet, safe-haven debt levels are in most cases worse than their weak counterparts, especially in the case of Japan, meaning deleveraging is a unilateral prescription. I won’t beat a dead horse on who could be the next Greece, but I do want to emphasize that deleveraging is a painful process, which can adversely impact growth. Eventually, in the U.S. tough austerity measures coupled with substantial tax increments will be necessary, transforming the fuel of the nascent economic recovery, fiscal stimulus, into fiscal drag. Japan’s likely the most at risk of the safe-havens with a vast amount of its debt financed domestically, by what is now a shrinking and ageing population; meaning external financing will ultimately be necessary. This could cause investors to reassess Japan’s stability. The good news is while tough measures in the US are necessary— creating significant economic headwinds— it should allow the nation to avoid the fate of Greece. Meanwhile, I recommend monitoring investor sentiment toward Japan as the canary in the coal mine for the U.S.

The AUD/JPY exchange rate, commonly used as a carry trade to take advantage of stark interest rate differentials between the two countries, is also a measure of investor risk. For that reason it may surprise some of you to learn the cost of the Australian Dollar in terms of the Japanese Yen is tightly correlated with the S&P500’s performance. Both trades invovle risk, and as investors appetite for risk diminishes so to does demand for equities, while demand investors rush into the Yen to quickly unwind their potentially highly levered carry trades.

Risk aversion has also kept the USD/JPY trading relatively range bound, but improving U.S. fundamentals coupled with Japan’s fiscal weakness could be setting the cross-rate up for a bounce. I expect that recovering investor sentiment, which will eventually lead to a decline in U.S. government bond purchases, will also coincide with a sharp depreication for the Yen in terms of U.S. Dollars. The chart below highlights how the relationship between the AUDJPY cross-rate against the USD/JPY rate has broken down since the start of 2009. I expect that USD/JPY rate will gradually increase to 100 from the current level of 93.25 as confidence returns to the market, and investors begin to digest the extent of Japan’s fiscal weakness. In fact, with the preface that Japan is no Greece, the country’s finance minister recently announced they wanted to extend the average maturity of Japan’s government debt to reduce its refunding risk. Japan’s debt to GDP ratio is expcted to hit 227% of GDP this year; Greece 110%…

Next week the Fed will cease purchasing agency MBS, to an industry outsider this innocuous sounding fact may not garner much attention, but the reality is the implications are likely very significant, and are already making themselves apparent in the market. Former Fed Chairman Alan Greenspan recently referred to last week’s jump in U.S. interest rates as a ‘canary in a mine’ towards further increments in the future. Mr. Greenspan’s fears stem from the federal government’s massive–unprecedented–deficit, which is not a U.S. exclusive phenomena. Outside of the U.S. I expect pressure will be put on rates from the U.K. to Japan, with Japan (debt to GDP approaching 200%) being the most susceptible to a loss in investor confidence over the short-term as it rolls over a significant amount of debt on a very near-term basis.

Source: Bloomberg

But, I digress back to the Fed. Since the start of 2009 the Fed has begun purchasing up to $1.25trn of Agency MBS securities, these purchases have helped keep interest rates low and combined with the first time home buyer tax credit stoked pretty solid gains in home sales through November of 2009. However, since then an extension to the first time home buyer tax credit has proved itself impotent in stirring new demand, and next week as the Fed stops purchasing MBS, mortgage rates will likely continue on last week’s upward trajectory, putting any housing recovery into further jeopardy. To help show the correlation between mortgage rates and the Fed’s MBS purchases I created the chart below. The chart shows the 4wk moving average of the net change of the Fed’s MBS position, overlaid with 30Y mortgage rights:

Source: Bloomberg

As the chart demonstrates, when the Fed’s purchases of MBS goes up, rates go down; and as their purchases go down rates generally go up. I continue to expect that as a result of the termination of the Fed’s MBS purchase program 30Y mortgage rates will likely rise anywhere in the vicinity of 25 to 50 basis points, which could be further exacerbated by rising treasury yields. Rising rates will put further strains on a stalling housing recovery, and may force the Fed to reinitialize the program, or come up with another means of supporting the real estate sector. However, as I mentioned in the beginning of this entry, the bigger story over the months ahead could lie in U.S. and international rates markets, where risks may not be properly priced in given weakening fundamentals, partially due to Keynesian policy responses to the recent crisis. On that note, I expect we will see 10Y treasuries yielding above 4% (to as high as 4.5%) over the short-term, and as for Japan and some of the other troubled European nations, beware.

While all eyes remain on Greece, Japan’s fundementals continue to weaken, and in some instances look worse than Greece. There are of course numerous technical and economic differences between the two nations; however, I do not believe Japan’s current deficits and debt load will be sustainable without drastic changes. This is an update from my piece titled ‘Positioning Yourself for Japan’s Potential Demise…’. The charts below illustrate some areas of concers for the Land of the Rising Sun:

Japan’s new finance minister has indicated that he would like to see the yen depreciate ‘a bit more’ after falling 9% from it’s recent high. This is in contradiction to Japan’s recently retired finance minister, and likely means further depreciation for the Yen. I first recommended shorting the yen on 28 October in my piece entitled ‘Positioning Yourself for Japan’s Potential Demise‘, either directly, through derivatives, or the ETF, YCS. I still believe the trade has good upside and a relatively low risk profile.

Since China opened the flood gates to foreign investment in the 1990s, the country has significantly outpaced the developed world, especially the US, in terms of economic growth (see Chinese vs. US real GDP growth chart).

Consequences of China’s success have included increased urbanization (see population chart) and a burgeoning middle class. Never before in China’s modern history have so many had so much, and with a population of over 1.3bn this has created more than just a blip on the map.

One statistic that best represents China’s blossoming middle class is domestic car sales, which have risen quite dramatically over the past five years (see domestic Chinese auto sales chart). But these increments are likely just the tip of the iceberg.

Prior to the global financial crisis, Chinese consumption was experiencing solid growth on the back of rising incoming bolstered by large levels of investment and a strong export industry (see consumption and income chart).

However, as economic turmoil spread around the globe, it became clear decoupling was more myth than reality, forcing the Chinese government to react. Realizing the frailties of an export-oriented growth model in the face of an external crisis, the Chinese government introduced an unprecedented US$586bn stimulus package designed to stoke domestic demand. The result: Chinese consumption remained robust while domestic demand in the US faced significant declines (see chart US retail sales vs. China).

Over the course of 2009, US corporations with high exposure to the region sought relief in China to help offset significant losses back home. One measure of China’s resilience over the US market is the fact that on a year over year basis, Chinese imports from the US fell by only -US$842mn, while Chinese exports to the US plummeted -US$5.9bn (albeit from a higher base) (see yearly change chart). Additionally, not all goods sold by US corporations in China are imported; many US companies have partnerships with Chinese companies and produce goods domestically. The list of companies that admitted to benefiting from strong consumer demand in China include Intel Corp., Caterpillar Inc., Coca-Cola, Alcoa Inc., Altera Corp., and Cummins Inc., just to name a few. Recently, Ford Motor Company announced the construction of a third factory in China to produce high-end sedans for sale in the country. There is no doubt the short-term effects of strong Chinese domestic demand has been positive for western companies. The question is, is it sustainable into the future?

The answer to that appears to be yes. Increments in consumption over the past decade may only be a drop in the bucket compared to the country’s full long-term potential. China’s government has realized the shortcomings of its investment and export led growth strategies, and will continue to focus on policy toward domestic demand. As Chinese Premier Wen Jiabao put it, “to boost domestic demand is a long-term strategic policy for China’s economic growth and the way for us to tackle the financial crisis and stave off external risks.”

But how much slack is in the system? China may have the world’s third largest economy, but on a per capita basis, China doesn’t even rank among the top 100 nations, falling between Armenia and Iraq (see per capita GDP chart). However, its performance in this metric has rapidly been improving.

According to McKinsey Global Institute (MGI), present day China, at least in terms of per capita GDP, holds a striking resemblance to the US circa 1850, the same period in which the US was undergoing its own industrial revolution. However, unlike the US in 1850, China’s consumption as a portion of GDP is amongst the lowest in the world — herein may lie the key to China’s true potential (see chart China’s personal consumption to GDP vs. US & Japan).

According to MGI, by 2025, with the adoption of effective government policies, the proportion of GDP attributable to consumption could recover recent losses begin catching up with the rest of the world. MGI estimates that under a best case scenario, China would be able to enlarge consumption’s share of GDP from the present level of 36% to 50% by 2025, while elevating nominal GDP to US$13.2trn, versus US$4.4trn in 2008. These estimates are arguably overly optimistic, but nevertheless the implications of such a jump are enormous—even MGI’s baseline forecast with policy changes has consumption/GDP moving up to 45.2%. If these forecasts come to fruition, China’s share of global consumption would jump to between 11% and 13%, meaning a quarter of all new global demand would be derived from the country. Applying linear growth rates to the organization’s forecasts, we can interpolate the projected growth of Chinese consumption through 2025 (see chart consumption forecast). Putting this into dollar terms, Chinese household consumption could increase from US$1.4trn in 2007 to US$6.6trn – US$5.2trn – in just 18 years. Contrast this to the past 20 years, during which Chinese household consumption increased by only US$1.3trn. Considering the effect US$0.7trn in consumption growth has brought China since 2000, any realization toward China’s full potential could surely change the world as we know it.

-Strong domestic demand for Japanese government bonds has permitted Japan to keep interest rates at or near 0 despite significant increases to the government’s debt burden, with no significant currency depreciation, and almost no economic growth. But, this model may be coming to an end

-An aging Japanese population will have several negative effects on the economy: 1) Higher taxes to fund the country’s pay as you go social security system. 2) Retirees will begin drawing from savings to fund retirements. & 3) Reduced demand for JGB’s will force the government to seek capital outside of Japan, which should lead to a run-up in rates. Any increase in interest rates should have substantial effects on the government’s ability to finance it’s debt.

-The ‘illusion’ of the YEN being a ‘safe-haven’ currency could soon dissipate. Not to mention the aforementioned issues, the bulk of Japan’s economic growth–and decline–has stemmed from the export sector. A strengthening Yen against its trading partners will add further pressure to this sector, and place additional pressure on Japan’s growth going forward.

Take a short position on the Yen versus USD:

*Buy USD/JPY puts

*Short YEN against USD (ETF: YCS)

Open a position to take advantage of anticipated rise in Japanese rates:

Contact Me:

Michael.McDonough@fiateconomics.com
Michael is an economist/strategist who has worked from Wall Street to Hong Kong primarily focusing on the U.S. and emerging markets. He has also written several columns. More

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